Rationale for Remuneration

With the IRS now scrutinizing executive compensation at nonprofit organizations, consider following recommended lines of defense and clearly documenting any practices beyond the norm.

By Kevan Buck and Richard V. Smith

Until recently, executive compensation was the business of the board that approved it and the leaders who received it. Today, however, the demand for transparency coupled with a tough economic climate has put increased emphasis on salary and benefits of top executives. While public companies have endured greater exposure for much of this decade, the light is now shining on nonprofit organizations, too.

This increased attention is in large part because in 2008 the Internal Revenue Service (IRS) overhauled the Form 990 for not-for-profit organizations—a short version of a public company's proxy. The new required disclosures open up college and university executive compensation—and the board's decision-making process—to examination by the IRS as well as by the broader public. Also in 2008, the IRS sent to 400 colleges and universities a 33-page questionnaire focusing on matters related to executive compensation practices, business income, and endowments, among many other areas. After reviewing the responses, the IRS has so far targeted 40 institutions for examination.

With regard to executive compensation, in July 1996, Congress created the intermediate sanctions rules. Prior to that, the IRS could only respond to excess benefit transactions (EBTs) by revoking the organization's tax-exempt status or ignoring the problem.

Since the emergence of intermediate sanctions, the IRS can impose excise taxes on (1) any disqualified person who engages in an EBT with a 501(c)(3) or 501(c)(4) tax-exempt organization and (2) certain organization managers who knowingly, willfully, and without reasonable cause participate in such a transaction. To maintain their tax-exempt status, 501(c)(3) organizations must assure that the compensation programs provided to their key personnel are reasonable and do not exceed the fair market value of the consideration the organization receives in return. In declaring a benefit an “excess benefit transaction,” the IRS determines whether the value of an economic benefit provided exceeds the value of the consideration received by the exempt organization.

The financial impact of an EBT can be severe, both for the individual recipient and for managers who approved the transaction. Penalties can include the following:

The recipient of the excess benefit is accountable for an initial excise tax of 25 percent on the amount of the EBT.

In addition, the recipient must “correct” the transaction by repaying the EBT. Failure to do so can result in an additional excise tax equal to twice the amount of the excess benefit.

All those who “knowingly, willfully” participated in the EBT—generally officers, directors, or trustees—may be personally liable for 10 percent of the amount of the excess benefit (up to $10,000 per transaction).

Say, for example, that three board members or trustees serve on the committee that approves the compensation of a university's new president. Based on compensation analyses presented at committee meetings, each trustee knows that the fair market value of the president's services does not exceed $350,000. Nevertheless, they approve setting the president's compensation at $450,000. Should the IRS audit the Form 990 and declare the president's compensation an excess benefit transaction, each trustee (as an organization manager) could be subject to an excise tax of $10,000 (10 percent x $100,000 excess benefit), or $30,000 in total. In addition, the president would be subject to an excise tax of $25,000 (25 percent x $100,000 excess benefit) and would be required to repay the $100,000 excess benefit, plus interest, to the university to avoid the imposition of an additional tax of $200,000 (200 percent of the $100,000 excess benefit). All fines must be paid by the principals from their personal funds, not from university accounts.

Regulatory and public scrutiny will continue to intensify in the next decade, potentially exposing trustees, executives, and organizations to considerable liability. There are, however, a number of steps that institutions can take to protect themselves. The most important involves establishing a “rebuttable presumption of reasonableness,” that is, a device that shifts to the IRS the burden of establishing that a transaction is an unreasonable excess benefit. Surprisingly, according to results gathered in the IRS Exempt Organizations Colleges and Universities Compliance Project Interim Report (released May 7, 2010), many institutions reported not using the rebuttable presumption procedure (45 percent of small institutions, 29 percent of midsize institutions, and 38 percent of large organizations).

Following is a summary of relevant IRS actions, their implications for both corporate and nonprofit organizations, and guidance—based in part on examples from the University of Tulsa (TU), Oklahoma—for chief business officers and other institution executives who wish to reduce the attendant risks. Included is a detailed explanation of the rebuttable presumption of reasonableness.

IRS Scrutiny Continues to Intensify

Publicly traded companies have now completed the fourth year of the new proxy disclosure rules. Proxy statement disclosures require detailed discussion of compensation philosophy, compensatory elements, and decisions made regarding the named executive officer's compensation in the Compensation Discussion and Analysis—the narrative disclosure about compensation practices and payments.

The content of an annual IRS 990 filing is just as important as the content of an institution's Web site, annual statements, and marketing materials.

Such compensation disclosure has now been imposed on the nonprofit world, specifically on 501(c)(3) and 501(c)(4) organizations. Accordingly, stakeholders, attorneys general, government agencies, and lawmakers are now focusing on executive compensation in the nonprofit, tax-exempt world as well as in the for-profit, publicly traded sphere. In fact, both the IRS and the Securities and Exchange Commission (SEC) want to increase the flow of information to the public, while requiring organizations to be more transparent in their disclosures about executive compensation.

Other new and existing requirements are also in play, including:

Public access to Form 990. As most of IRS Form 990 is open to public inspection, the document is significantly more than an annual tax filing. The required information is designed to inform the public about the way tax-exempt organizations operate. Consequently, the Form 990 is a window into the workings of the institution, and everyone can examine the view—from IRS examiners, potential students, and donors, to competitors, media reporters, politicians, and civic groups.

Given this level of visibility, the content of an annual IRS 990 filing is just as important as the content of an institution's Web site, annual statements, and marketing materials.

Compliance with recent IRS initiatives. Along with the requirements for greater disclosure, the IRS, over the past several years, has launched a series of initiatives to examine executive compensation compliance. These address the salary and benefits of specific individuals with regard to instances of questionable compensation practices. The IRS first reviewed the compensation packages of hospital executives, and then began to scrutinize pay arrangements for leaders of political action committees, credit consultancies, community foundations, and—most recently—colleges and universities. The intent is to increase awareness of tax issues as organizations set compensation in the future and also to learn more about the practices organizations are following as they set compensation and report it to the IRS and the public.

In examining compensation, the IRS reviews salaries, fees, bonuses, severance payments, deferred compensation, benefits and perquisites, property transfers, loans, internal and external business dealings, and any other forms of compensation derived from related organizations or entities.

Protect Your Institution

Compensation Comparisons Underpin Pay Practices

The University of Tulsa (TU), Oklahoma, worked with Sibson Consulting to compare executives' compensation to the compensation paid by similarly situated organizations, both taxable and tax-exempt, for functionally comparable positions. The consulting firm used both current compensation surveys compiled by independent firms and data from peer group institutions—those with which TU competes for executive talent. The study also considered the availability of similar services in TU's geographic area. Where they were available, the analysis reviewed actual written offers from similar institutions competing for the services of the executive.

Variances of less than 20 percent generally reflect an incumbent's tenure, relative performance, or other common differences in the attributes of incumbents at this level within an organization. Therefore, institutions generally consider variances in compensation level statistics that are greater than 20 percent as significant for analysis purposes when reconciling an employee's compensation as being within an acceptable range or below or above market.

The analysis also reviews the institution's compensation philosophy—the guidelines it uses to establish its pay practices and compensation levels. The philosophy specifies how the institution positions itself against the market—does it pay at the median of the market, or above or below median, and by how much? Market positioning that differs from the market median requires context and rationale.

Just as important, the third-party analysis looks objectively at the decision making that surrounds compensation—how decisions are made, by whom, and based on what data and analyses. The process for determining compensation must include comparability data, review and approval by independent persons, and substantiation of the compensation deliberation and decision at the time it is made.

At TU, the board's compensation committee reviews the outcome of the study along with recommendations. TU then has an independent third party review the president's pay and that of other highly paid executives on a regular basis and provide the committee with regular updates in a comprehensive report.

It is important for boards and committees responsible for an institution's compensation arrangements to (1) understand the elements of the institution's compensation package and ensure that any practices beyond the norm have a clearly documented rationale and (2) consider putting in place a rebuttable presumption.

Awareness and preparedness. Institution administrators must make clear to board and committee members the importance of adopting compensation-setting practices that require detailed explanation. If not reasonable, the following elements of compensation may attract the attention of the IRS and other interested reviewers:

Base salary above the market median.

Bonuses and incentive payments that are subjective and formulaic.

Other compensation, particularly severance, income earned in prior years but paid in the current year, and qualified and nonqualified retirement contributions.

Deferred compensation.

Select nontaxable benefits, such as housing, education, life insurance, and gross-up payments.

Severance or change-of-control payments.

Supplemental nonqualified retirement plan payments.

Payments or bonuses contingent on revenues or net earnings.

Initial contract exceptions to general compensation policies.

Other nonfixed compensation, triggered either by an event or performance-based payments.

Any outstanding loans to or by a current or former officer, director, trustee, key employee, or highly compensated employee, including certain forms of life insurance, such as split-dollar plans.

Any interlocking business or family relationships with other organizations.

Reimbursements for first-class, charter, spousal, or companion travel; tax indemnification and gross-up payments; discretionary spending accounts; housing allowances; business use of a personal residence; health or social club dues; and the services of a maid, chauffeur, chef, or the like.

While these forms of compensation may be permissible, the institution must have a solid rationale for providing them and establish clear policies addressing their tax treatment. In addition, leadership should be able to show that all compensation provided fits within the institution's overall compensation plan and philosophy.

The University of Tulsa, for example, recommends that the trustees of the compensation committee be provided a comprehensive half-day tutorial on Form 990 reform and the possible consequences of nondisclosure or of violating the rules against excess benefits. Sibson Consulting assisted TU in establishing this process as well as providing the university with periodic updates to keep the committee fully informed of any changes or new initiatives that could possibly affect the university's current compensation policies and procedures.

Establishing a rebuttable presumption of reasonableness. The regulations provide for a rebuttable presumption that compensation arrangements are reasonable if the “authorized body” obtained and relied on “appropriate data as to comparability” prior to making its determination. Developing such a presumption requires the institution to take the following steps:

1. Obtain approval by an independent board or committee. The compensation arrangement is approved in advance by the board of trustees (or a committee of independent nonemployees who do not have a conflict of interest or a material interest in the arrangement or transaction under consideration).

2. Use comparable data. In approving the transaction, the board of trustees or independent committee obtains and relies on appropriate comparability data. The information is sufficient to allow the determination that the transaction is indeed reasonable. Relevant information may include for-profit or not-for-profit compensation surveys or data compiled by independent firms, reflecting similar size, complexity, and location of the institutions being compared. All compensation elements are considered as they relate to functionally comparable positions.

3. Document that compensation decisions align with a formally stated compensation philosophy. Attracting a senior executive can no longer fall under the category of ad hoc negotiation or an attempt to “make a deal.” Rather, the board of trustees or independent committee adequately documents the basis for its approval, the rationale for which is consistent with formally stated policies of statistical compensation pay-level targets and position-comparison methodologies.

Institutions can fortify a rebuttable presumption of reasonableness by providing the opinion of an objective third party. If your institution's leadership decides to take this step, contract with an independent third party to conduct a comprehensive analysis of compensation practices and payments to your officers, directors, and key employees, and compare them to the practices of several colleges and universities of the same size, scope, location, and so forth. Such a study assesses all elements of compensation, including base salary, cash compensation, and total compensation—including benefits and perquisites. (See sidebar, “Compensation Comparisons Underpin Pay Practices.”)

TU established a rebuttable presumption by forming an independent compensation committee within the board that oversees all disqualified persons, especially the president and other highly paid employees. The committee also adopted a compensation philosophy that directly correlates to the levels of compensation provided to each executive. Additionally, TU's committee established a sound peer group of like institutions of similar size and characteristics to provide benchmark comparisons. Finally, TU retained an independent third-party consultant with expertise within higher education institutions to perform a competitive and reasonable compensation assessment that validates compensation levels according to the compensation philosophy. With these components in place, TU established a strong rebuttable presumption.

Having a rebuttable presumption in place, however, is not a guarantee that the IRS will not follow up on an institution's disclosure. The benefit of a rebuttable presumption is that should the IRS single out the institution for inquiry, the IRS—not the institution—bears accountability for establishing that a transaction is an unreasonable excess benefit.

Other safeguards. Additional protections to ensure that compensation is reasonable and can withstand scrutiny include the following:

Review senior executives' compensation every other year; review the president's compensation every year.

Unwind any forms of life insurance that are considered loans.

Respond expeditiously to a notice from the IRS. In most cases, the inquiry will request an explanation about something that was misunderstood in Schedule J (the supplemental compensation section) of Form 990. Often such inquiries can be clarified easily. But failure to respond promptly could trigger a deeper discussion.

A study of the preliminary changes nonprofit organizations have made to the new Form 990 and the other IRS initiatives described earlier shows mixed reactions. (See sidebar, “Tax-Exempt Institutions' Form 990 Submission Trends,” for information on survey responses.)

Adjusting Expectations

The overall trend toward transparency shows all signs of continuing, and institutions can expect continued scrutiny as the furor over executive pay expands from the corporate to the nonprofit sector. With bonus and performance pay more visible, compensation packages for CEOs and key officers remain controversial. Consequently, boards have a growing responsibility to exercise diligence in setting executive pay levels and policies. This is also an opportunity to ensure that compensation is in keeping with institution mission and that practices are in the best interest of all stakeholders, including the recipients, the students, and the trustees.

KEVAN BUCK is executive vice president, University of Tulsa, Oklahoma, and is also immediate past chair of the NACUBO Board of Directors; and RICHARD V. SMITH is a senior vice president and principal, Sibson Consulting, New York City, and the company's Executive Compensation and Corporate Governance Practice leader.